Use Tax: States Get Aggressive

In their persistent efforts to require direct marketers to collect state use taxes, several state legislatures have developed a new aggressive strategy. They are trying to use the purchasing power of state government agencies to circumvent the constitutional standard established in 1992 by the Supreme Court in Quill Corp. v. North Dakota, which requires that a retailer must have a physical presence in a state before it can be obligated to collect that state’s use taxes.

In the 2003 and 2004 legislative sessions, at least nine states — including California, Connecticut, Georgia, Illinois, Indiana, Missouri, New Jersey, Virginia, and Wisconsin — adopted laws that obligate out-of-state retailers to waive the constitutional “nexus” protection they enjoy under Quill as a condition of being permitted to sell to state agencies. Such a law has been on the books in Tennessee since 2001, and similar legislation is being considered in other states.

Some of these laws directly impose tax registration and collection obligations on any retailer doing business with the state. But most of the statutes achieve their objective by prohibiting state agencies from contracting with any vendor that makes taxable sales in the state but does not collect use tax on all of its sales. Several statutes do, however, contain limited exceptions, which allow state agencies to contract with vendors that do not collect use tax in cases of emergency or where a vendor is the sole source of the relevant goods or services.

These statutes are an attempt by the states to leverage their purchasing power to collect taxes from remote sellers who, under Quill, do not have an obligation to pay them. Further, most of these laws make eligibility for state contracts dependent upon tax collection not only by the interested vendor but also by all of the vendor’s “affiliates,” regardless of whether the affiliates engage in business with any state agency.

These types of state statutes are of doubtful constitutionality. The issue is whether a state can refuse to deal with an out-of-state retailer unless the seller agrees to waive its constitutional rights under the Commerce Clause and commit itself to the burden of collecting and remitting use taxes on sales unrelated to the state’s purchases.


State revenue departments and attorneys general will likely try to defend these laws against constitutional attack by relying on the so-called market participant exception to the Commerce Clause protection of interstate commerce from burdensome and discriminatory state laws. The market participant doctrine was recognized by the Supreme Court in Hughes v. Alexandria Scrap Corp. in 1976. Hughes concerned a Maryland statute under which the state paid a fee for every Maryland-titled automobile converted into scrap. The statute imposed more-stringent documentation requirements on out-of-state scrap dealers than on Maryland scrap dealers. The practical effect of the state law was that virtually all junk cars were processed at Maryland scrap yards. An out-of-state scrap dealer challenged the statute.

The U.S. Supreme Court upheld the Maryland law on the grounds that a state may adopt restrictions with respect to its “proprietary activity.” The court concluded that the Commerce Clause did not bar a state “from participating in the market and exercising the right to favor its own citizens over others.”

But in a subsequent decision, the Supreme Court set limits on a state’s right to use its purchasing power to interfere with interstate commerce. In Reeves, Inc. v. Stake (1980), the court made clear that the market participant exception draws a “basic distinction…between states as market participants and states as market regulators.” In other words, the doctrine does not protect state action that goes beyond participation in the marketplace and into the realm of regulation of interstate commerce.

The Supreme Court has since rejected the application of the market participant exception in a refusal-to-deal case involving a state law analogous to the recently enacted state statutes that prohibit state agencies from purchasing products from vendors that do not collect state use tax on their regular consumer sales. In Wisconsin Dept. of Industry, Labor & Human Relations v. Gould, Inc. (1986), the Supreme Court invalidated a Wisconsin statute that prohibited repeat violators of the National Labor Relations Act from doing business with the state. Although the primary basis for the court’s ruling was on other grounds, the court found that “by flatly prohibiting state purchases from repeat labor law violators Wisconsin ‘simply is not functioning as a private purchaser of services,’…for all practical purposes, Wisconsin’s debarment scheme is tantamount to regulation.”

The question in any legal challenge to a state law prohibiting state agencies from contracting with vendors that refuse to collect use tax on their unrelated sales to in-state residents is likely to be whether the statute falls within the market participant exception to the Commerce Clause or whether the statute instead constitutes impermissible, discriminatory regulation of interstate commerce.

The requirements of these statutes go far beyond market participation; their objective is to impose a regulatory taxation scheme that would otherwise clearly be banned under the Commerce Clause. These states are not acting as market participants, they are seeking to regulate markets beyond their own, including those in which affiliates of state contractors operate.

The constitutionality of these laws is highly suspect. With the growing popularity of such measures among state legislatures, a constitutional challenge may not be long in coming.

George S. Isaacson, tax counsel to the Direct Marketing Association, is a senior partner at Lewiston, ME-based law firm Brann & Isaacson; Matthew P. Schaefer is an associate at Brann & Isaacson.